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Understanding Bonus Annuities - A Regulatory Update

August 14, 2000
The new "bonus" variable annuity has to be one of the most successful and controversial variable annuity designs in recent years, attracting media headlines and increasing scrutiny from federal and state regulators in both the securities and insurance arenas.

Sales of bonus annuities nearly doubled in 1999, to $17.3 billion, with VARDS reporting that 20% of 1999's top 25 variable annuity contracts were bonus products, with that percentage expected to reach one-third in 2000.

Headlines such as "SEC Scrutinizes Bonus Credits" have appeared in major newspapers. In June 2000, the SEC published an online brochure, "Variable Annuities: What You Should Know," with a section devoted to bonus annuities that cautions investors to understand the downside, as well as the upside, of bonus products.

Bonus variable annuities typically give the investor a front-end credit applied to each premium, generally in the range of 1% to 5%, with some variations. The bonus is generally added to contract value from the insurer's general account each time a premium is paid, but the bonus often does not "vest" for a year. In other words, insurance companies will recapture the bonus credits in certain instances, such as on cancellation of the contract during the free-look period, on withdrawal, death or annuitization, depending on when the bonus credit is applied. (To recapture the full dollar amount of the bonus credit, the insurer must obtain exemptive relief from the SEC.)

Bonus products often have somewhat higher charges and longer surrender charge periods. In some cases, the death benefit may be less favorable, or other benefits may be scaled down or not available.

Bonus contracts frequently are sold in a tax-free 1035 exchange for a fixed or variable annuity with little or no remaining surrender charges. The bonus credit may be used in the sales process to overcome investor reluctance to pay any remaining surrender charges.

The SEC has expressed concerns about bonus annuities, focusing on the product's fees and charges and the potential suitability issues raised by the high level of 1035 exchange activity generated by bonus programs. Paul Roye, Director of the SEC's Division of Investment Management, has noted his agency's concern with the potential for sales practice abuses due to the fact that the costs of the bonus may be less visible than the bonus itself.

As part of the heightened federal scrutiny, the SEC is requiring insurers to add additional disclosures to their bonus product prospectuses and is cutting down on exemptive relief to "recapture" the bonus. The NASD has issued a regulatory alert informing members that all advertisements and sales literature promoting bonus products must include a prominent explanation that the fees and expenses may be higher, and the surrender periods longer, than contracts that do not provide bonus features. In addition, Mr. Roye has called on insurance companies and selling firms to develop and implement an appropriate level of suitability monitoring and compliance procedures with regard to bonus products.

As regulatory scrutiny increases, insurers are devoting considerable resources responding to the regulators' demands regarding the disclosure, regulatory compliance and suitability monitoring of bonus product offerings.
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